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Monday, October 27, 2008

Misalignment: Options At Lehman Brothers

As a shareholder, you must be extremely cognizant of how the management team of your company is compensated. An ideal compensation structure pays executives enough such that they're not worried about meeting their family obligations, but otherwise aligns their interests with those of shareholders. Contrary to popular belief, stock options do not align manager interests with those of shareholders, as we've discussed here.

But when CEO Richard Fuld of the now bankrupt Lehman Brothers recently testified before the House of Representatives, this is how he answered a question regarding the compensation he has received in the last few years:

"We had a compensation committee that spent a tremendous amount of time making sure that the interests of the executives and the employees were aligned with shareholders...because we wanted them to think, act and behave like shareholders. When the company did well, we did well. When the company did not do well, we did not do well."

This is absolutely incorrect! Due to the hundreds of millions of dollars in options Fuld received, his interests were not aligned with those of shareholders (if they were, he would not have received $350 million, while the long-term shareholders are left with nothing!). Options encourage managers to take great risks (resulting in the possibility of huge paydays) with little consideration to large losses (as an option can't be worth less than zero!), whereas compensation in the form of restricted stock encourages managers to be aware of downside risks and consider long term shareholder value.

Did Fuld let Lehman tank because he made his money and just didn't care? Such an accusation is without basis. However, the excessive use of options as compensation undoubtedly encouraged management to take risks, which led to Lehman's eventual demise. University of Chicago Finance Professor Luigi Zingales is not alone in his opinion when he states "Lehman's demise was a result of its aggressive use of leverage". Aggressive use of leverage results in huge profits and huge losses...we saw them both happen at Lehman thanks to a gross management/shareholder misalignment that ended up costing shareholders, but not management.

Before you become a shareholder in a company, look for its compensation structure in its annual proxy filing (a regulatory requirement), and politely decline to invest if confronted with excessive use of options as compensation for management.

2 comments:

I would want them to be a small part of the executive's overall compensation. Furthermore, they should also be a small part of the executive's overall ownership of the company. Ideally, they shouldn't be used at all.